Hortz: What are the key regulatory issues related to registered crypto funds?
Howell: The novelty of crypto-based funds and their potential risks mean they must undergo regulatory scrutiny by the SEC’s Division of Investment Management, which reviews all new mutual fund and ETF filings. To meet these regulatory requirements, the fund’s sponsor, its legal counsel and other service providers must respond to numerous comments and requests for information from the SEC and its staff. As registrants navigate the regulatory gauntlet, they’re likely to encounter 10 key issues, each of which I walk through in a recent blog post:
1. Fund name and strategy
2. Investments in other pooled investment vehicles
3. Liquidity and capacity constraints
4. Concentration
5. Valuation
6. Leverage
7. Roll strategy (futures funds only)
8. Extreme market conditions
9. Derivatives risk management
10. Environmental impact
To date, the SEC has not permitted any registered investment company to invest directly in cryptocurrencies on a principal basis. And the only crypto derivative that’s permitted as a primary investment in registered funds is CME Bitcoin futures. I believe CME Ethereum futures will be next, but there are some technical and market hurdles that need to be cleared before registered funds can primarily invest in that asset.
Hortz: Please share with us your experiences in helping one of your fund management companies register a Bitcoin futures fund. Are there any differences or steps you must take for crypto versus other mainstream fund products?
Howell: Given the novelty of digital assets in mainstream capital markets, launching the product required close engagement with the SEC. At the end of the day, we were successful in launching the fund because IDX Advisors and the fund’s administrator were familiar with both digital asset markets and the regulatory landscape, and they were able to demonstrate that this type of fund was ready for a mutual fund structure. It also helped that a few other products launched shortly before ours, including the ProShares Bitcoin Strategy ETF (BITO).
But launching the product wasn’t easy. The SEC staff is still learning about these asset classes and developing regulatory policies to address them. The staff’s initial concern focused on the underlying market, primarily liquidity. But crafting disclosure for Main Street investors was also challenging. First movers need to lead a significant education effort because investors are still developing crypto literacy. We worked closely with SEC staff to make sure the investment and risk disclosure were complete, accurate, and easy for Main Street investors to understand.
Additionally, the current regulatory rules were not written with digital assets in mind. It’s challenging to take rules written in 1940, 1975, and even 10 or 20 years ago for traditional assets like equity or debt and make them work for newer asset classes like cryptocurrencies, non-fungible tokens, and DeFi products. Market participants need to engage with the SEC staff and help craft a regulatory framework that works for market participants, regulators, and investors.
Hortz: Can you give us your perspective on this apparent battle between the SEC and the CFTC over who regulates the growing crypto marketplace?
Howell: Currently, the SEC and the CFTC are racing to be the preeminent regulator of cryptocurrencies and crypto-related assets. The CFTC claims that crypto derivatives like futures and options are a commodity interest regulated by the Commodity Exchange Act of 1934, a law that was created long before crypto. Because of a lack of legal authority over currencies, the CFTC is trying to regulate derivatives of cryptocurrencies, but not the currencies directly. Unlike currencies, which are regulated by the Federal Reserve and Treasury Department, futures, options, and derivatives fall under the CFTC’s authority. The CFTC can regulate futures and options markets but not “spot” markets, where commodities (like soybeans and copper) are traded directly. Most digital coin exchanges are considered spot markets.
The SEC is staking its claim on the definition of a security, which includes investment contracts as established in the 1946 Supreme Court case of SEC v. Howey. Oddly, the SEC has already said that Bitcoin and Ethereum, the two largest cryptocurrencies by market size, are not securities. But the SEC is trying to regulate initial coin offerings (ICOs), which would apply to any new cryptocurrencies hitting the market, not those already in circulation. The SEC is also going after DeFi products related to lending and borrowing crypto on decentralized platforms. Since these instruments are more akin to debt, they’re more clearly in the SEC’s purview. And the SEC is going after crypto-related companies that have issued stock or other securities to investors. Those securities offerings, whether registered or unregistered, are also clearly in the SEC’s authority.
Hortz: What do you see as the way forward on all these issues?
Howell: The fact remains that digital assets like cryptocurrencies don't fit neatly into the SEC’s regulatory framework. It’s a bit of a stretch to conclude that cryptocurrencies are a security, but digital assets that represent interests in startups, companies, and the like look more like securities. The rising popularity of decentralized autonomous organizations (DAOs) as investment clubs is another area where securities law and crypto assets cross paths. Regardless of the accuracy of the SEC’s position, the crypto markets will see increased government regulation in the years to come, and many participants welcome it - as trust grows in these markets, more investors will participate. One group that would welcome crypto clarity is registered investment advisors, whose clients are increasingly interested in cryptocurrencies as part of their investment portfolio.
Hortz: Any recommendations or advice you can offer any advisors or fund managers looking to develop crypto investment products?
Howell: Learn. Learn. Learn. RIAs and fund managers can’t simply chase another hot investment product. They need to have a working knowledge of how the underlying technology works, the risks to that technology (e.g., a blockchain fork or pending upgrade to the protocol), and the property rights attached to digital assets. Since digital assets are not tangible, often the only underlying property rights are intellectual property rights. If a crypto asset is supposed to represent an “ownership” interest in an underlying company, you may need more documentation than a simple token purchase to evidence ownership of the underlying asset (e.g., a smart contract).